HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Lecture 8 Financial Statement Analysis: For the Investor DR. AZIZ JAAFAR

Financial Leverage The use of debt is referred to as financial leverage Interest as related to debt financing A contractual obligation Must be paid regardless of entity’s current profits Contrast with dividends which are discretionary Interest is tax deductible Reduces taxable income Reduces income tax

Definition of Financial Leverage and Magnification Effects Net income increase [A] is greater than change in EBIT [B] due to the fixed nature of interest expense

Computation of the Degree of Financial Leverage The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT A more simple formula for degree of financial leverage

Computation of the Degree of Financial Leverage (cont’d) Degree of financial leverage calculations should exclude Minority share of earnings Equity income Nonrecurring items The all-inclusive formula for degree of financial leverage

Earnings per Share Required disclosure for corporate income statements Pertains only to common stock Per-share amounts are disclosed for Income from recurring items Discontinued operations Extraordinary items Net income

Basic Earnings per Share Earnings pertain to an entire fiscal period Average common shares outstanding is used for parity of information

Weighted Average Common Outstanding Stock dividends and stock splits Retroactive recognition to all comparative data

Earnings Per Share and Capital Structure Simple capital structure Complex capital structure contains potentially dilutive securities: Options, rights, warrants Convertible debt Convertible preferred equity Contingent shares

Price/Earnings Ratio Measures the relationship between the market price of a share of common stock and that stock’s current earnings per share Use of diluted earnings per share gives more conservative price/earnings ratio

Price/Earnings Ratio (cont’d) Compare with Industry competitors Industry average Exchange (e.g., NYSE) average Interpretation High-growth-potential firms have higher P/E ratios P/E ratio is a function of the market

Percentage of Earnings Retained Reflects the proportion of current earnings retained for internal growth Trend analysis is improved by exclusion of nonrecurring items Higher percentage typically found in New firms Growing firms and firms perceived as growth firms

Dividend Payout Measures the portion of current earnings per common share being paid out in dividends A stable dividend policy is developed by consideration of recurring earnings Lower payout typically found in New firms Growing firms and firms perceived as growth firms

Dividend Yield Indicates the relationship between the dividends per common share and the market price per common share The yield is a function of The firm’s dividend policy Market price

Book Value per Share Preferred equity should be measured at liquidation value, if available Market value vis-à-vis book value Book value reflects past unrecovered asset costs Market value reflects the potential of the firm

Stock Appreciation Rights Employee receives compensation in cash or stock Difference between option price and market price Expense is a function of market price Year-end spread is measured Current expense is spread minus prior recognition

Stock-Based Compensation May be awarded through the use of Stock options Restricted stock Stock appreciation rights Firms vary in their use of these methods of granting stock-based compensation Select a single method Use two of the three methods Use all three in combination